Friday will see the first major shock to the netting and clearing system for CDSs. This event in the form of the Lehman default will see an estimated $400b attempted to be cleared through a system that is frightfully low on liquidity and thus becoming tightly coupled. Even the world's central banks are running dry trying to loosen the system. The US alone pumped in $430b on Wednesday.
Some counter parties will be short or late on their $400b settlements due to liquidity problems. This is a form of Herstatt risk. New Posthe systemic risk is that counterparties to the counterparties will become nervous sending more waves into a fragile system. The possibility of "the day money disappeared" is now very real.
The cause is something I refer to as CDS chain settlement risk explained here. It is caused by multiple parties owing each other in a causal chain. In times of proper liquidity, it is a negligible-issue. We are not in such a time and our central banks are in a poor position to resolve the issues.
The global coupling of the system has been tightened due to liquidity constraints and the Central banks are in many instances the only reliable sources for funding. Paul Kedrosky highlights the problem here.
The $50 trillion of CDS held by JPMorgan is assumed to be a part of the problem. The FED has a few choices to keep the banking system alive, including holiday's, extreme liquidity offers and declaring a special situation for resolution. The tricky part about a potential solution is the requirement for the most orchestrated and co-ordinated multiple central bank activity seen, for the scope of the issue is global.
Here is a simple explanation. Imagine a system of linked pendulum. The weight is a bank or counterparty such as an insurance company. Typically the banks gain or lose capital swinging forward or backward due to the market. Occasionally the banks bump into the banks next to them (counterparties).
In the CDS example a shock (payment failure) cascades down the settlement chain and is dampened with only excess liquidity. A loosely coupled system finds the weights spread far apart with low interactions. The tightly coupled system with low liquidity such as we now find, brings the weights close together. A single shock can ripple through the system.
In the system pictured at the left, a wire from which the weights are suspended doesn't move much, it is fixed. Unfortunately 3 things are coinciding to make the system turn chaotic and unpredictable.
The system is becoming tightly coupled, more susceptible to shock, the shocks are happening more often from more sources, and the system is gaining its own harmonic as behavioural fear takes over as seen in the TED spread.
Harmonics in tightly coupled systems don't work well as seen in this video, a stable well designed bridge. The winds weren't high but due to the systems design, it failed. Our financial system is robust, but had a systemic design failure which is now potentially manifesting itself into a systemic failure.
